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The Economic Storm Ahead

 With the near-simultaneous release this morning of CBO's updated Budget and Economic Outlook and OMB's Mid-Session Review, we have the most detailed economic analyses and forecasts we are likely to see for the rest of the year.

If the consensus these documents represent is in the ballpark, the country and the Obama administration are in for a rough ride. Consider the following:

After shrinking over 2009, real GDP will grow only anemically in 2010 before that growth accelerates for a few years and then subsides to below 3 percent for the second half of the decade.

Unemployment will remain persistently high, averaging about 10 percent in 2010, when Democrats will be trying to defend their recent congressional gains. It will be close to 9 percent in 2011, but remain well above 7 percent as late as 2012, when President Obama presumably will run for reelection.

After years of economic recovery and growth, budget deficits will remain larger throughout the next decade than most economists (and the administration) consider acceptable, raising debt held by the public to between 67.8 percent (CBO) and 76.5 percent (OMB) of GDP by the end of the decade.

CBO’s forecast, which is required by law to take current legislation as its baseline, assumes that all the Bush tax cuts as well the AMT patch will expire on schedule without being renewed, increasing revenues sharply, and that no new spending initiatives will be adopted. But hardly anyone believes that taxes will be allowed to rise that much (the administration isn’t recommending it), so revenues are likely to be lower than the forecast. And if any portion of the administration’s health care proposal is adopted, federal spending will be even higher than the 23.5 percent of GDP the administration projects for the next decade (CBO projects a near-identical 23.4 percent average). Bottom line: Deficits are likely to be even higher than either document predicts.

How can we pay for this much government and finance deficits this large? In recent years, the answer could be summed up in one word: China. But the evidence suggests that we can’t count on this in the future. From a high of 55 percent in 2006, China’s willingness to finance the U.S. deficit has fallen to only 9 percent in the first half of 2009. In the short term, as much of the global economy remains sluggish and the appetite for risk remains low, this won’t matter much. Within a few years, however, the tension between private sector borrowing and the public sector’s need is bound to increase, with increasingly unpleasant consequences for interest rates and growth.

In its mid-session review, the administration acknowledges that “the fiscal situation will demand more action once the economic recovery is fully underway” and that health insurance reform won’t be enough to do the job. If the president and his economic team mean what they say, they will be compelled to propose significant changes in the entire federal budget, including revenues and entitlements. But it’s not clear that many members of Congress from either party would be willing to step up to the plate. In any event, the ability of the United States to govern itself realistically and maturely will be tested, and the consequences of failure will be severe.

UPDATE: Because Noam Scheiber’s post also addresses the issue of China’s willingness to continue financing the U.S. budget deficit, I thought it would be useful to lay out the Treasury’s numbers more fully. In 2006, China purchased 55 percent of the annual increase in U.S. Treasuries outstanding. That fell to 33 percent in 2007, 22 percent in 2008, and 9 percent in the first half of 2009. If current trends continue, China will purchase about $145 billion this year, versus about $275 billion in 2008. This suggests that while the Chinese have many reasons not to destabilize our economy, their willingness to finance our deficit is waning. And if they accept the advice of just about everybody to deemphasize exports to the U.S. and build up their domestic market, the quantity of Chinese savings--public and household--available for overseas investment is bound to decline. It would, I repeat, be unwise to assume that the rest of the world would be willing to finance $9 trillion of new U.S. debt over the next decade on terms we would find attractive. So bringing that number down is more than a green eyeshade exercise; sustainable growth depends on it.